Avoiding Frequent IRA Rollover Mistakes

IRA rollovers at first seem commonplace and easy. There even are television commercials about them. Yet, there is a lot more to rollovers than many people realize. When you don’t know the details, you risk losing money to taxes, penalties, and bad decisions.

There are 31 different types of rollovers in the tax code, says CPA Ed Slott. For example, converting a traditional IRA to a Roth IRA technically is a rollover. Rollovers can occur at times other than retirement. While these choices provide a number of potential benefits, they also are fraught with traps for the unwary or careless. You want to avoid making the most common rollover mistakes with your money.

The 60-day IRA rollover. In this rollover you physically receive money (usually a check) or property from a traditional or Roth IRA and plan to roll it over to another IRA. When you physically receive a distribution from an IRA, you have to deposit the same amount with the trustee of a different IRA, the same IRA, or an employer qualified retirement plan within 60 days. Fail to meet the 60-day deadline and the distribution is included in your gross income. You might owe a 10% early distribution penalty if you are under age 59½.

While often advertised as a 60-day interest-free loan, the 60-day rollover is fraught with peril. You can be hit with the taxes and penalties for unintentional mistakes and oversights that cause the deadline to be missed, even if others are at fault. It’s best not to try the 60-day rollover at all. Instead, to move IRA funds use the trustee-to-trustee transfer.

In 2014, the IRS amended its rules to allow the 60-day transfers only once per year per taxpayer. That limit is once per 12-month period, not once per calendar year. It also applies to all types of IRAs. If you make a transfer from one traditional IRA to another, you can’t make a transfer from your Roth IRA during the same 12-months. Excepted from this limit are conversions of traditional IRAs to Roth IRAs, rollovers between qualified plans and IRAs, and direct transfers between ira trustees.

IRA trustee-to-trustee transfer. The safest way to move funds from one IRA to another is to have it transferred between the trustees or custodians. You don’t touch the money. You tell the trustee of the IRA you want to receive the money to have it transferred from the other IRA. After you complete the paperwork, the trustee handles the transaction.

You still need to be vigilant. There are numerous cases of financial firms mistakenly transferring money from an IRA to a taxable account, making the transaction a taxable distribution. Other mistakes also can be made. The IRS has limited discretion to correct or provide waivers for these mistakes. Closely review the paperwork and have errors fixed quickly.

401(k) to IRA rollovers. This is the most common type of rollover and the one mentioned in the television commercials. There are several pitfalls to avoid.

Financial services firms work hard to convince people to transfer their 401(k) balances to IRAs after leaving an employer, whether for retirement or for other reasons. The first mistake many people make is not considering their other options.

The money can remain in the 401(k) under most plans. You might want to do this if the plan has good investment choices, low expenses, and if the employer will continue to communicate well with and offer full plan services to former employees who left their accounts with the plan. The 401(k) also provides more protection from creditors than an IRA does. Another 401(k) benefit is you might be able to take loans from a 401(k), but not from an IRA. Some 401(k) plans, however, allow loans only to active employees. Consider all these factors before deciding to move from the 401(k).

Another option, when you left to take another job, you might be able to roll the balance to your new employer’s plan. If the new plan has attractive features and you want to consolidate most of your funds in one place, this could be a good choice.

When the account includes employer stock, you probably don’t want to roll this over to an IRA. The tax code provides breaks to employer stock when it is distributed to a taxable account instead of being rolled over to an IRA in certain circumstances.

The account balance also could be taken as a lump sum. For those born before 1930, there are some tax benefits to that, but not many people today are likely to qualify. Those who take the account in a lump sum and don’t qualify for the special treatment will include the entire lump sum in gross income.

Finally, there’s the option of rolling over the 401(k) balance to an IRA. This gives you full control over the money and the option of investing in all the assets available through the IRA custodian. If the custodian is a brokerage firm, you can invest the IRA in almost anything in the markets. Fees might be lower, depending on the fees charged by your 401(k) plan. The IRA rollover also has the potential of allowing you to consolidate all your financial accounts at one firm. The IRA rollover also gives you more flexibility at required minimum distribution time than a 401(k) does.

You also can roll over the IRA to a true self-directed IRA custodian that will let you invest in unconventional assets such as real estate, small businesses, and loans to individuals.

The rollover from the 401(k) to the IRA is tax free. You can do either a trustee-to-trustee transfer or take the account balance in a check and personally deposit the amount in an IRA or the new employer’s plan. But when you take a check, 20% of the account balance will be withheld as taxes. To make the rollover tax free you have to come up with cash to replace the 20% and be sure your entire pre-distribution account balance is rolled over.

Inheritances by non-spouses. Some of the biggest rollover mistakes are made by beneficiaries of IRAs and 401(k)s. The most common is to roll over the inherited account to an IRA owned by the beneficiary or a new IRA set up in the beneficiary’s name. This causes the entire account balance to be treated as distributed, even if it still is sitting in an IRA.

To continue deferring taxes on an inherited IRA, the beneficiary must have the account retitled to indicate it is inherited. That means including the name of the original owner, an indication that he or she is deceased, and a statement that it is an IRA “for the benefit of” (or FBO) the beneficiary.

The beneficiary might want to roll over the account to a financial services firm where his or her other accounts are maintained. To do this properly, the inherited account first must be renamed as just described. Then, a new IRA must be set up at the desired firm with the exact same title as on the inherited IRA. Only then can a tax-free rollover occur.

Non-spouse beneficiaries also can’t do a 60-day rollover in which they take possession of the money. Only a trustee-to-trustee rollover is allowed. If the beneficiary receives cash, check, or property from the inherited IRA, it is included in gross income. If the beneficiary takes possession for even a moment, it is a distribution and can’t be reversed.

When the beneficiary takes money out of the IRA or 401(k), he’ll be taxed the same as the original owner would. So, taking a lump sum distribution causes the entirety of after-tax amounts to be included in gross income.

The spousal rollover. When a spouse inherits an IRA or 401(k), he or she can take the same actions a non-spouse beneficiary can. The spouse also has the option of rolling the account into an IRA in his or her name and receiving a “fresh start.” It will be treated the same as an original IRA of the spouse.

One potential mistake is that an inheriting spouse can’t do the spousal rollover until he or she is at least age 59½. Younger surviving spouses have to wait until after age 59½ to do the rollover or face penalties. The inheriting spouse also has to remember to name new beneficiaries of the IRA, because the contingent beneficiaries named under the deceased spouse’s IRA or 401(k) won’t automatically apply to the new IRA.

Rolling over after-tax money. The tax law limits the amount of income that can be tax-deferred into a 401(k) plan each year. Additional contributions are allowed, but the additional amounts are included in gross income. These additional amounts are after-tax contributions. You have a basis in them equal to the amount that was included in gross income. When the account is distributed, the basis, or after-tax amounts, aren’t included in income. Many plans allow these additional after-tax contributions to be made, but not all do. You need to check plan rules.

The IRS issued rules in 2014 that show how after-tax 401(k) contributions can be turned into Roth IRAs. When you decide to rollover your 401(k) to an IRA, you can separate the pre-tax and after-tax contributions. The pre-tax contributions can be rolled over to a traditional IRA tax-free as is usually done. The after-tax contributions can be rolled directly to a Roth IRA, and there are no additional taxes paid.

To receive this treatment, you must roll over the entire IRA in the same year. The after-tax contributions go to a Roth IRA, and the pre-tax contributions go to a traditional IRA. These rollovers also must be done trustee-to-trustee. You can’t receive the funds personally and then try to roll them over. The new rules make it easier for higher-income employees to eventually have Roth IRAs.

RW May 2015.